Discharged Student Loans & Cancellation of Debt Income – How the COD Income May Not Be Taxable

Normally, when a taxpayer has a debt cancelled or discharged, the taxpayer is required by the Internal Revenue Code (IRC) to report the amount of the loan on a tax return as cancellation of debt (COD) income.  However, when it comes to Federal Student Loans, there can be exceptions to that rule.  Federal student loans include Federal Family Education Loans, Federal Perkins Loans, and Federal Direct Loans.

The Department of Education (ED) can use the following procedures to discharge Federal student loans:

  • Closed School
  • Defense to Repayment

Under the Closed School discharge process, the ED can discharge a Federal student loan if the student was attending a school at the time it closed or if the student withdrew within a certain period before the closing date.

Under the Defense to Repayment discharge process, the ED is required to discharge a Federal Direct Loan if a student (borrower) establishes, as a defense against repayment, that the school’s actions would give rise to a cause of action against the school under applicable state law.  Federal Family Education Loans can also be discharged under this procedure if certain additional requirements are met.

There are statutory exclusions (outside of the IRC) from taxable gross income for COD income from Federal student loans discharged under the Closed School discharge procedure. Therefore, a taxpayer whose loan is discharged under this procedure shouldn’t report the related COD income as taxable gross income.  However, there is no statutory gross income exclusion for COD income from loans that are discharged under the Defense to Repayment procedure unless the taxpayer is deemed insolvent or is in bankruptcy.

Fear not – the IRS has actually come to the rescue for students who attended schools owned by Corinthian Colleges, Inc. (CCI).  In a recent Revenue Procedure, the IRS said that taxpayers who took out Federal student loans to attend schools owned by CCI, that were then discharged under the ED’s Closed School or Defense to Repayment procedures, need not recognize taxable gross income as a result of the discharges. The Revenue Procedure also states that these taxpayers are not required to increase their Federal income tax or taxable income to account for higher education tax credits, college loan interest deductions, or tuition and fee deductions that were claimed for expenses that were financed by discharged loans.

On a side note, it is becoming a more common compensation practice for employers to pay off student loans incurred by their employees. When that happens, it is not a COD event. Instead, it is a taxable compensation event. Student loan amounts that are paid off by employers are simply treated as additional compensation received by the affected employee (student loan borrower).  As such, these amounts are subject to Federal income and employment taxes, and possibly state income tax as well.

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